Registered Investment Advisor – Hampton Roads, Virginia

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Mutual fund share classes are little understood by the investing public, but they are important because they determine how much the investor pays in fees.

Fund classes are identified by an alphabetical letter that follows a mutual fund’s name in most newspapers.

Mutual fund “A” share classes typically have a “front-end load,” a sales charge payable when you buy the fund. This fee is used to pay the brokerage firm and part of it goes to the broker who sells the fund.

The amount of the load depends on the kind of fund – bond funds generally have lower loads than stock funds – and the amount of money invested. The more money that’s invested, the lower the fee. Known as “break points,” they refer to points at which front-end charges go down. For example, the front-end load for the Growth Fund of America class A shares is 5.75% on investments up to $25,000. But if you invest $1 million dollars or more the front-end load is 0%.

Mutual fund “B” shares typically have a “back end load” payable when you redeem the shares. These decline over a period of years (usually 6 to 8 years) until they finally disappear.

Both “A” and “B” shares usually have an “12b-1” marketing fee, generally 0.25%, charged annually.

Class “C” shares have no front-end load, a small back end load, usually 1%, that goes away after 1 year. However, they have higher 12b-1 fees, typically 1%.

There are other share classes such as I, Y, F-1, F-1, F-2. In fact, some funds have as many as 18 share classes. They are all the same fund; the only difference is the fee charged to the investor.

Many fund families offer “institutional” share classes that are only available to certain investors. Institutional shares are purchased by businesses who are in the investing business such as banks, pension funds, insurance companies and registered investment advisors (RIAs) who buy them as agents for their clients. This is one of the benefits of working with an independent RIA who has access to lower cost funds, load waived funds and no-load funds that are often not offered by the major Wall Street firms.

Liquidity is defined in the Dictionary of Finance and Investment Terms as “the ability to buy or sell an asset quickly and in large volume without substantially affecting the asset’s price.”

In layman’s terms it means being able to get to your money quickly and without a major loss. Liquid assets are things like checking accounts and money market funds. They can also include mutual funds and stocks in large companies that trade on a major stock exchange, although in times of severe financial stress even these may see major price swings.

But there are lots of things people own that are not liquid. The typical family’s home is a large part of their wealth. Homes are not liquid; they can’t be sold quickly and converted to cash in times of need. What a home can be sold for is a guess; something that millions of people learned when the housing bubble burst in 2008. Families found that the value of their home was tens, even hundreds of thousands of dollars less than their mortgage.

Besides a home, many stocks are not liquid. Shares in small companies with a few shares outstanding may not be liquid. Even the very wealthy are finding out that the liquidity trap can turn them from billionaires to paupers in short order. Forbes Magazine listed Elizabeth Holmes, the founder of Theranos, as America’s richest self-made woman last year with a fortune estimated at $4.5 billion. The most recent listing gave her net worth at zero. The reason for this is fairly simple. Her net worth was based on the value of one stock: Theranos. The stock was not publicly traded and if she had tried to sell some of it the share price would have plummeted because it would show a lack of confidence in the future of the company.

So when Theranos ran into serious problems Holmes could not get out and her fortune literally disappeared into thin air.

The average person can avoid the liquidity trap by following a few simple rules.

Do not put too much of your personal wealth in things – like homes – that can’t be easily sold.

Do not put too much of your personal wealth in one stock. You do not want your net worth to evaporate because of poor decisions by corporate management.

Smart investors spread their financial assets widely. Realizing that they cannot accurately predict the future, they own stocks and bonds, domestic and foreign. If they don’t have the means to diversify using individual stocks and bonds they use mutual funds or ETFs.

Get an advisor. Most smart people use professionals when they need medical, legal or financial advice.

The 401(k) plan is now the primary retirement plan for employees in the private sector and Ted Benna isn’t happy. Benna is regarded as the “father” of the 401(k) plan but now he calls his child a “monster.”

There are several problems modern with 401(k) type plans.

They are too complicated. The typical 401(k) plan has dozens of investment options. These are often included to satisfy government regulatory demands for broad diversification. For the plan sponsor, who has a fiduciary responsibility, more is better. However, for the typical worker, this just creates confusion. He or she is not an expert in portfolio construction. Investment choices are often made when an employee gets a new job and there are other things that are more pressing than creating the perfect portfolio. Which leads to the second problem.

Employees are given too little information. Along with a list of funds available to the employee, the primary information provided is the past performance of the funds in the plan. However, we are constantly reminded that past performance is no guarantee of future results. But if past performance is the main thing that the employee goes by, he or she will often invest in high-flying funds that are likely to expose them to the highest risk, setting them up for losses when the market turns.

There are no in-house financial experts available to employees. Employee benefits departments are not equipped to provide guidance to their employees; that’s not their function. In fact, they are discouraged from providing any information beyond the list of investment options and on-line links to mutual fund prospectuses. Doing more exposes the company to liability if the employee becomes unhappy.

What’s the answer? Until there are major revisions to 401(k) plans, it’s up to the employee to get help. One answer is to meet with a financial advisor – an RIA – who is able and willing to accept the responsibility of providing advice and creating an appropriate portfolio using the options available in the plan. There will probably be a fee associated with this advice, but the result should be a portfolio that reflects the employee’s financial goals and risk tolerance.

Did you ever hear about the famous feud between the Hatfield and the McCoys? They lived in the mountains on the West Virginia/ Kentucky border in the late 1800s. It all began in a dispute over a hog and led to the death of two dozen people over a 20 year period. As time passed the original reasons were lost and the feud became a deadly habit.

Most people are creatures of habit. Some habits are a good thing. It’s a substitute for rethinking a lot of things we do automatically: we shower, brush our teeth and eat breakfast mostly out of habit rather than spending time wondering if we should. It makes our lives easier.

The habit of saving money for retirement is also a good thing. It’s a habit that leads to financial success. But what we do with that money can lead to bad habits. Getting into the habit of investing in the same thing year after year can lead to bad results.

For example, Microsoft (MSFT) has made some people – like its founder Bill Gates – one of the richest men in the world. Adjusted for stock splits, it was $0.10 /share in 1986; today it’s about $54/ share, a gain of over 54000%. However, if you had bought it in 1999 hoping to see that trend continue you could have paid $59/per share. You would still be waiting to break even, having lost money over a 17 year period.

Unfortunately, this is the kind of habit that so many investors exhibit. They may buy stock in a company they work for and develop the habit of sticking with it even if the company has problems. General Electric (GE) has tens of thousands of employees who bought its stock. They saw the price drop from $60/share to $6/share between 2000 and 2009.

They may read about a mutual fund in a magazine or on-line and buy it without doing the appropriate research and add to it out of habit. Habits are a substitute for thinking about our actions. Some habits, like exercise and punctuality are good. But we should avoid falling into the trap of making investment choices out of habit. To do so can lead us to the same fate of the investor who bought Microsoft 17 years ago or GE 16 years ago and is still waiting to get even.

One way to avoid the trap of using habits to make investment choices is to regularly re-examine your investments. Ask yourself if you had cash, would you buy the same things you currently have in your portfolio? If you don’t know the answer, this is the time to get professional guidance from an investment professional, a trusted fiduciary who has your best interests at heart.

A Separately Managed Account (SMA) is an investment account managed by a professional investment manager that can be used as an alternative to a mutual fund. They provide diversification and professional management. But they differ from mutual funds in that an SMA investor owns individual stocks instead shares in a fund.

Here are some of the benefits of SMAs.

Customization: Investors in SMAs can usually exclude certain stocks from their portfolio. They may have an aversion to certain stocks, such as tobacco or alcohol. Or they may have legal restrictions on owning certain stocks. SMAs allow some customization that’s not available in mutual funds.

Taxes: Investors in SMAs can take advantage of tax loss harvesting at the end of the year by instructing a manager to sell certain stocks to reduce capital gains taxes. In addition, an SMA has another advantage over mutual funds in that each stock in an SMA is purchased separately. Mutual fund investors are liable for “embedded capital gains” even if the shares were purchased before the investor bought the fund shares.

Transparency: You know exactly what you own and can see whenever a change is made in your account. Mutual fund investors don’t see the individual securities they own or what changes are being made by the portfolio manager.

These are features that are attractive to certain investors. However, they are not for everyone. Most SMAs require minimum investments of $100,000. That means that they are only appropriate for high net worth investors who will typically use several SMA managers for purposes of diversification. In addition, the fees associated with SMAs are often higher than fees for mutual funds.

An acquaintance recently asked me how his money should be invested. With banks paying virtually zero on savings, it’s a question on everyone’s mind. Should he invest in stocks or bonds? If it’s stocks, what kind: Growth, Value, Small Cap or Large Cap, U.S. or Foreign? The same can be asked of bonds: government or corporate, high yield or AAA, taxable of tax free? That’s a question that faces many people who have money to invest but are not sure of where.

It’s a dilemma because we can’t be sure what the future holds. Is this the time to put money into stocks or will the market go down? If we invest in bonds will interest rates go up … or down? How about investing in some of those Asian “Tigers” where economic growth has been higher than in more developed countries?

There is no perfect answer. We are not gifted with the ability to read the future. And what is this “future” anyway? Next week? Next year? Or 20 years from now when we will need the money for retirement?

We know that generally, people who own companies usually make more money that people put their money in the bank. Another word for “people who own companies” is “stockholders.” That’s why, over the long term, stockholders do better than bondholders. On the other hand, bonds produce income and are generally lower risk than stocks. So my first answer to the question I was asked is: invest in both stocks and bonds.

Choosing the right stocks and bonds is a job that is best left to professionals. That’s the benefit of mutual funds. Mutual funds pool the money of many investors to create professionally managed portfolios of stocks and bonds. They are an easy way of creating the kind of diversification that is important for reducing risk.

To circle back to the original question our friend asked: the answer is to create a well diversified portfolio. We know that some of the time stocks will do better than bonds, and vice versa. We know that some of the time foreign markets outperform the U.S. market. We know that some the time Growth stocks will do better than Value stocks. We just don’t know when. So we select the best funds in each category and measure the over-all result. With so many funds to choose from, the smart investor will get help from a Registered Investment Advisor like the folks at Korving & Company.

“Passive Investing” has become very popular with investors as some financial writers and the index industry tout the benefits of buying an index fund. It’s said to be the kind of “set it and forget it” investment strategy that appeals to people who have limited investment experience and believe they are doing both the “smart” and “safe” thing.

But there is a downside that people who are not familiar with index funds are not aware of. It’s what happens when an investment “Bubble” breaks.

Legg Mason wrote an informative white paper on this subject recently. We want to quote some of what they said.

The end of a market bubble is never pleasant, but it can be especially painful for investors in passive strategies that track major stock indexes. A key reason: those indexes tend to increase the weighting of rapidly rising sectors as bubbles inflate, setting up investors for a bigger fall.

When sector bubbles collapse over shorter time periods, the overweights can impact major market indexes as well. Example: as the Internet bubble of the late 1990s collapsed, the weight of the S&P 500 Info Tech sector, one of the ten sectors represented in the S&P 500, shrank by more than half, from 33.3% to 15.4%, as the sector generated a cumulative loss of 73.8%. The same effect could be seen during the global financial crisis, with financials plummeting nearly 80%.

Investors investing $1000 in the very popular index that tracks the NASDAQ market would be investing roughly $120 dollars in Apple, $90 in Microsoft and $50 in Amazon. More than $500 of that investment would go into only 10 stocks. This is an illustration of the fact that the investor who believes that buying an index provides broad diversification may find out that this may not be the case. While buying an index is not necessarily a bad idea, it should be done understanding how indexes are constructed and the amount of risk it involves.

These are only a small sample of the kinds of distortions reflected in passive capitalization-weighted indexes, whose construction forces them to overweight sectors as they become more popular with investors. When added to the well-documented tendency of investors to herd toward supposedly “hot” opportunities, the damage to investment returns can be substantial.

The core issue, however, is not that every success contains the seeds of its own destruction. Rather, it’s that using conventional passive, index-based investing as the center of a balanced investment strategy can introduce unexpected — and unwanted — volatility into a supposedly conservative portfolio, at just the moment when investors may be seeking refuge. And that’s the real trouble with bubbles

The hidden dangers of investing, even in the most common strategies, are just another reason to get professional advice.

When people think about traditional mutual funds they typically think about funds known as “open ended funds.” They are the most commons funds. Shares of the fund are bought or sold though the fund company. There are no limits to the number of shares that can be issued and shares prices are determined once a day, after the market closes. At that point the total value of the assets in the mutual fund are determined and divided by the number of shares. This is the “net asset value” (NAV) and everyone who buys a share on that day pays the same price and everyone who sells also gets the same price, not matter what time of the day the order to buy or sell has actually been entered.

“Exchange Traded Funds” (ETFs) are newer but have become popular because they are bought and sold like a stock and are traded on major exchanges. The price of the shares can fluctuate during the day and the price that an investor pays for the shares can be different from minute to minute, just like the price of a stock will fluctuate during the day. That means that an ETF can be bought in the morning and sold in the afternoon for a profit or a loss depending on the change in value. The market price of an ETF is kept near the NAV by large institutional investors who will detect any difference between the NAV and the actual share price and use “arbitrage” to make that difference go away.

Because ETFs are more flexible in terms of trading strategy, they have become very popular with many active investors and speculators. In addition, because many ETFs are “passive” funds they often have lower expense ratios than many traditional mutual funds.

There are a number of other issues that an investor should be aware of with ETFs such as liquidity, commissions to trade, the bid-asked spread, and the viability of any specific ETF.

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There are more mutual funds that there are stocks on the NY stock exchange. To make sense of the variety here are some of the most common fund types.

• Money market funds. These are funds that invest in very short term, liquid securities that offer a safe place to put cash. They offer a very low rate of return but try to maintain a net asset value of $1 per share.

• Stock funds (equity funds) invest primarily in stocks. They are subdivided into many categories according the size of the companies they invest in (large cap, small cap), the investment style (growth, value) and geography (US, Foreign).

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Sales Charges
Some funds (load funds) sold by brokers, insurance agents or investment advisors have a front-end sales charge which is paid by the investor and passed along to the seller for his services. The charge is deducted from the amount being invested.

Other mutual funds (no load funds) are offered directly to the investing public by fund companies, or they are offered to investors by financial intermediaries who have a compensation arrangement (hourly, flat fee or a percentage of assets) with the purchaser. In this case, a sales charge is not involved, and the investor fully invests his or her available money into funds sponsored by a no-load fund company.

There are several other arrangement by which load mutual fund companies compensate sales people that are less obvious than front end sales charges in a variety of fund share classes – A, B and C. Many fund families offer special no-load share classes (F-1, F-2) for fee-based advisors who want to use their funds but do not want their clients to pay a sales charge. Before anyone invests in a mutual fund it is important that the investor understands how the broker, salesperson or investment advisor is compensated.

Expense Ratio
A mutual fund’s expense ratio is the amount of money that the fund charges for running the fund. It is usually shown as a percentage of the fund assets. All mutual funds charge investors a fee for their services. In general, passively managed index funds have a lower expense ratio than actively managed funds and bond funds have a lower expense ratio than stock funds.

Redemption Fee
Many mutual funds are charging a fee if the investor withdraws his money from a fund within a certain specified time of making an investment. This is designed to discourage market timing which can complicate the process of managing a fund.